The pension puzzle

In 2003 there were over 61,530 pensioners in Malta (18 per cent of the population) but by 2050 the figure will be 104,140 (31.2 per cent), according to government projections. Over the next four decades we will see the number of persons working for every person receiving a pension go down from roughly 5.8 persons in 2003 to 2.2.

Amid much talk of crisis, the government has published a White Paper on Adequate and Sustainable Pensions. Just how worried should we be?

All societies try to meet people's needs as they age and can no longer provide for themselves. In many countries, long-established pension systems that have sufficed for decades are now threatened. The demographic time bomb has set off an intense debate about pension reform in general and particularly about whether it is necessary or desirable to move away from government pay-as-you-go pensions towards private or publicly-funded plans.

With so many countries now engaged with these issues, the time is right for reflective discussion of the economics of pensions and the prerequisites for establishing new systems as well as for adapting the mature, older ones.

Broadly, the objectives of all pension systems are threefold: to provide security against destitution in old age; to smoothen the distribution of consumption spending over a life span, shifting part from the more productive years to the least; and to provide life's requirements for those with exceptional longevity.

All pension systems, no matter how financed, require that the government manages the economy effectively enough to provide adequate growth while establishing a strong regulatory environment. The much-debated choice between government pay-as-you-go and funded schemes (whether private or public) is of secondary importance.

Much discussion of pensions gets bogged down in arguments over what types of financial portfolios are safest or grow fastest, whether government promises are more secure than assets owned or held in the names of individuals and which generation foots how much of the pension bill. Ideological strife heightens the confusion and the economic fundamentals of all pensions get lost.

As Malta grows, it faces difficult issues about how to establish pension systems that our more complex economy requires. A low take-up of voluntary pension schemes (an NSO survey found that less than 20 per cent of the population have life assurance) and a high burden of social-security pensions are rightly seen as major disadvantages.

The implications of the White Paper are that, because the option of poorer pensioners is undesirable, some combination of higher taxes, higher savings and/or a higher average retirement age is needed. No single solution makes sense. The way forward must involve some mix of a major revitalisation of the voluntary (private) system, changes to the state system and increased levels of compulsion.

The report provides a powerful wake-up call, emphasising the need for reform of the state system and better incentives to save. To be successful, any such reforms would need bipartisan support and stability, which have been absent to date.

Several themes recur in any attempt to secure the resources needed for individuals at the ends of their lives. These themes are the central importance of national output to the viability of all pensions; the pervasive risks and uncertainties that all pension schemes face and the imperfect information available to consumers.

¤ Output is the key: To attain security in old age, individuals must either save part of their earnings to afford buying goods and services later from younger workers or they may rely on a promise from children, an employer, or the government to provide goods and services in their retirement years. Both funded and pay-as-you-go plans are claims on future output. They are of no use to retirees if the country is not producing enough goods and services to meet those claims.

¤ Risk and uncertainty: Both private funded plans and government pay-as-you-go systems are subject to risk and uncertainty. Risks include theft or mismanagement of privately held assets or the inability of governments, companies or trade unions to make good on pension promises.

¤ Imperfect consumer information: Since nobody knows the future, government pension administrators, private fund managers and individuals all face the issue of imperfect information and high potential cost of mistaken choice. This requires the stringent regulation of pension management to protect consumers.

There are a number of problems which affect all contributory pensions. These issues include:

¤ Lack trust of in pensions: The failure of financial institutions in several countries has led many people to question whether it is worth entrusting their savings to them and how certain they can be of their pension.

¤ Shortfall in funds: With life expectancy still increasing, many funds are having to provide payments for longer than they originally calculated.

¤ Low interest rates: In the last few years the pension you would receive when investing your annuity has decreased by about 25 per cent as a result of low interest rates and low inflation. Annuities offer much better returns when inflation and interest rates are higher.

¤ Inflexible pensions rules: Investors cannot access any reserve of funds in times of hardship.

¤ Reliance on financial advisers: With so many types of private pensions available, people are often unable to understand them even with expert advice. Not only does this increase the potential for selling people the wrong pension but the fees paid towards pension administration and advice means less money makes it into the pension fund.

We can only reform the pension scheme to the extent that the government and the private sector are mature enough to manage the chosen new system or the reform plans. The role of the government is to assure both the fiscal and political sustainability of the pension system.

If we eventually put strong reliance on private financial markets and investments, our financial markets will need to develop further, while there will need to be adequate public and government understanding of and trust in them. This may seem obvious but there is still a pervasive belief that if a fund is "private" and the money "invested", a high real rate of return is inevitable.

Although the basic requirements for all sound pension systems are extensive there are a range of difficult, often controversial, choices to meet their varied capacities and needs.

One of the most important issues is how large the first-tier pension should be. The first tier could take the form of a state guarantee to individuals in private schemes, as in Chile, under which only the least-well-off receive any state pension. Or the state pension could be awarded on the basis of an affluence test, as in Australia.

Somewhat less stringently, the first-tier pension could be flat-rate (hence going to all pensioners): It could be a flat-rate below the poverty line; equal to the poverty line (broadly the case in the UK) or above the poverty line (as in Malta and New Zealand).

Another issue is whether there should be a second-tier pension. A second-tier pension could provide for spreading consumption more equally between working and retirement years. The major argument for a mandatory second-tier pension is that imperfectly informed younger people will make poor choices from the perspective of their lifetime needs as well as that it ensures insurance against unknowable events.

From an individualistic perspective the issue points towards a voluntary third-tier pension.

This list far from exhausts all the potential questions. What, for example, should be the tax treatment of contributions to the third tier? Should such savings receive tax concessions? Should those concessions be available only for savings for old age or also for other purposes such as life insurance, house purchase, or education? And what form should any tax concessions take?